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AICPA CPA-Business Exam - Topic 3 Question 60 Discussion
Topic #: 3
Assume the following facts about Martin Corporation:
* The long-term debt was originally issued at par ($1,000/bond) and is currently trading at $1,250 per bond.
* Martin Corporation can now issue debt at 150 basis points over U.S. treasury bonds.
* The current risk-free rate (U.S. treasury bonds) is 7 percent.
* Martin's common stock is currently selling at $32 per share.
* The expected market return is currently 15 percent.
* The beta value for Martin is 1.25.
* Martin's effective corporate income tax rate is 40 percent.
Based on these assumptions, what is the current net after-tax cost of debt for Martin Corporation?
Choice 'c' is correct. 5.1 percent current net cost of debt.
The fact pattern states that debt can be currently secured at 150 basis points above the Treasury bond rate. A basis point is equal to 1/100 of 1% (1% of 1%).
Applying the decimals it's:
150 basis points x 1/100 of 1% (or .0001)
this yields .015 or 1.5%
Add the additional basis points converted to percentage (1.5%) to the Treasury bond rate of 7% to arrive at the pre-tax debt cost of 8.5%. Apply 1 - tax rate to arrive at the current net cost of debt as follows:
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